Of the five investment strategies we considered earlier this month (Turning dogs and deals into profit, January 12), the winner by a significant margin was the high yield portfolio, which ended last year 23 per cent higher than it started.

However, ranking stocks on the basis of their dividend payout (measured as a percentage of the share price) isn’t the most scientific of methods for stock picking.

For instance, a high yield can just as often be a sign of financial distress as it is of strength, although this perhaps misses the point of high yield investing. The approach is not all about the income, it is also a means of spotting the diamonds in the rough.

Top ten yielding stocks

Michael O’Higgins’ Dogs of the Dow
strategy does this by picking the highest yielding blue-chip stocks,
surmising they have been over-sold. An anomalously high yield offered an
easy way to spot the real value plays of the elite Dow Jones Industrial
Average, he figured. This potential to generate growth and income
suggested it was worth taking a closer look at the market’s high
yielding stocks.

As expected, mechanically screening
for yield alone threw up a mixed bag. Caught in the filter alongside the
bargain stocks were what can be best described as the financially down
at heel (the yield being inflated by a sharp fall in the share price).

Dividend cover points to a company’s ability to fund and maintain the payout, and by extension its financial strength.

We introduced this as a filter
(setting a minimum cover of two times earnings), but it still created a
large and unwieldy portfolio. Perhaps the simplest approach to whittling
down the list was the one pioneered by O’Higgins.

Creating a ‘dogs portfolio’ required
nothing more analytical than being able to spot the FTSE 100’s ten
highest dividend payers.

And the strategy has a long track
record of consistently outperforming the market. O’Higgins’ back testing
of his theory proves this.

However, the variety of ‘dog stocks’
that our model generated was fairly limited. Three of the ten were
insurers and two were from the drugs sector.

A modified portfolio of Footsie shares gave a broader sweep of the sectors, but it also diluted the average yield.

Perhaps the most interesting screen
we looked at was the one pioneered by the American Association of
Individual Investors (AAII), which identifies high yielders that may
have been temporarily hobbled but have the ability to bounce back.

While the yield is a major
consideration, other factors are taken into account such as the
company’s track record for paying and increasing the dividend.

The top stocks in the portfolio had
an unbroken streak of increasing the payout that spans nine years and an
average yield over the past five of up to 5 per cent.

Closer analysis also showed they also
pay out a significant proportion of their earnings to investors. This
modified AAII strategy has logged an annualised return of 35 per cent since
inception, according to data from online share screening service
Stockopedia, and the portfolio of shares it generated last year was up
28 per cent over 12 months.

The spread between sectors and the split between large, medium and small-cap gives far more variety than our ‘dogs portfolio’.

However, at 31 individual stocks it
is perhaps a little too cumbersome. So for the purposes of this article
we have cut it down to the ten top shares (see our table).

Finally, research has shown that
reinvesting the quarterly and half-year dividend payments has a
significant impact on the overall return from the portfolio over a
period of years. Many of the FTSE 100 companies operate dividend
reinvestment plans, as do share registrars such as Capita and Equiniti.

The DRIP system works by lumping all
share purchases together, meaning trading costs are minimal on such a
deal. The downside of this is you don’t really get a say as to when the
shares are bought.

Investors using online share trading
accounts accumulate dividend payments in their cash balances. This means
they can reinvest the money as and when they like.